Thursday, February 25, 2016

Last week I asked whether the Federal Reserve couldget rid of the $100 bill. This week let's discuss whether it should get rid of the $100. I don't think so. The U.S. provides the world with a universal backup monetary system. Removing the $100 would reduce the effectiveness of this backup.

Earlier this week the New York Times took up the knell for eliminating high value bank notes, echoing Larry Summers' earlier call to kill the $100 in order to reduce crime which in turn was a follow up on this piece from Peter Sands. More specifically, Summers says that "removing existing notes is a step too far. But a moratorium on printing new high denomination notes would make the world a better place."

As an aside, I just want to point out that Summers' moratorium is an odd remedy since it doesn't move society any closer to his better place, a world with less crime. A moratorium simply means that the stock of $100 bills is fixed while their price is free to float. As population growth boosts the demand for the limited supply of $100 notes, their price will rise to a premium to face value, say to $120 or $150. In other words, the value of the stock of $100 bills will simply expand to meet criminals' demands. Another problem with a moratorium is that when a $100 bill is worth $150, it takes even less suitcases of cash to make large cocaine deals, making life easier—not harder—for criminals. To hurt criminals, the $100 needs to be withdrawn entirely from circulation, a classic demonetizaiton.

With that distinction out of the way, let's deal with three of the motivations for demonetizing high denomination notes: to reduce criminality, to cut down on tax evasion, and to help remove the effective lower bound.

Criminality

Summer's idea is to kill the $100 bill so that criminals have to rely on smaller denominations like $20s. Force criminals to conduct trade with a few suitcases filled with $20 bills rather than one suitcase filled with $100 bills and they'll only be able to jog away from authorities, not sprint. What sorts of criminals would be affected? The chart below (from this article by Peter Sands) builds a picture of cash usage across the different types of crime.

As the chart illustrates, the largest illegal user of cash is the narcotics industry. So presumably the main effect of a ban of $100s will be to raise the operating costs of drug producers, dealers, and their clients.

But should we be sacrificing the benefits of the $100 bill in the name of what has always been a very dubious enterprise; the war on drugs? An alternative way to reduce crime would be to redefine the bounds of punishable offences to exclude the narcotics trade, or at least certain types of drugs like marijuana. Law enforcement officers could be re-tasked to focus on the cash intensive crimes that remain, like human trafficking and corruption. In that way crime gets more costly and we get to keep the $100 to boot, which (as I'll show) has some very important redeeming qualities.

Tax Evasion

Cash is certainly one of the best ways to evade taxes, but there are other methods to reduce tax evasion. For instance, Martin Enlund draws my attention to a tax deduction implemented by Sweden in 2007 for the purchase of household related services, or hushållstjänster, including the hiring of gardeners, nannies, cooks, and cleaners. In order to qualify the services must be performed in the taxpayer’s home and the tax credit cannot exceed 50,000 SEK per year per person. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.*

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to get their tax credits, many of these transactions would have been pulled into the open.

We can evidence of this in the incredible decline in Swedish cash demand ever since:

Sweden has the distinction of being the only country in the world with declining cash usage. The lesson here is that it isn't necessary to sacrifice the $100 in order to reduce tax evasion. Just design the tax system to be more lenient on those market activities that can most easily be replaced by underground production.

Escaping the lower bound

Yep, those advocating a removal of $100s are right. Central banks can evade the effective lower bound on interest rates and go deeply negative if they kill cash, starting with high denomination notes.

But as economists such as David Beckworth have pointed out, you can keep cash and still go deeply negative. All a central banker needs to do is adopt Miles Kimball's proposal to institute a crawling peg between cash and central bank deposits. This effectively puts a penalty on cash such that the public will be indifferent on the margin between holding $100 bills or $100 in negative yielding deposits.

Another way to fix the lower bound problem is a large value note embargo whereby the Fed allows its existing stock of $100 bills to stay in circulation but doesn't print new ones (much like Summers' moratorium). This means that if Yellen were to cut deposit rates to -2% or so, the price of the $100 would quickly jump to its market-clearing level, cutting off the $100 as a profitable escape route. As for the lower denominations, the public wouldn't resort to them since $20s are at least as costly to hold as the negative rate on deposits. Unlike Miles' proposal a large value note embargo doesn't allow for a full escape from the lower bound, but it does ratchet the bound downwards a bit, and it keeps the $100 in circulation.Why should we keep it?

The $100 bill is the monetary universe's Statue of Liberty. In the same way that foreigners have always been able to sleep a little easier knowing that Ellis Island beckons should things go bad at home, they have also found comfort in the fact that if the domestic monetary authority goes rotten, at least they can resort to the $100 bill.

The dollar is categorically different from the yen, pound or euro in that it is the world's back-up medium of exchange and unit of account. The citizens of a dozen or so countries rely on it entirely, many more use it in a partial manner along with their domestic currency, and I can guarantee you that future citizens of other nations will turn to the dollar in their most desperate hour. The very real threat of dollarization has made the world a better place. Think of all the would-be Robert Mugabe's who were prevented from hurting their nations because of the ever present threat that if they did so, their citizens would turn to the dollar.

I should point out that the U.S. gets compensation for the unique role it performs in the form of seigniorage. Each $100 is backed by $100 in bonds, the interest on which the U.S. gets to keep. So don't complain that the U.S. is providing its services as backup monetary system for free.

Foreigners who are being subjected to high rates of domestic inflation will find it harder to get U.S dollar shelter if the $100 is killed off; after all, it costs much more to get a few suitcases of $20 overseas than one case of $100. This delayed onset of the appearance of U.S. dollars as a medium of exchange will also push back the timing of a unit of account switch from local units to the dollar. As Larry White has written, money's dual role as unit of account and medium of exchange are inextricably linked. People will only adopt something as a unit of account after it is has already been circulating as a medium of exchange. A switch in the economy's pricing unit is a vital remedy for the nasty calculational burden imposed on individuals and businesses by high inflation. The quicker this tipping point can be reached, the less hardship a country's citizens must bear. The $20 doesn't get us there as quick as the $100.

So contrary to Summers, I think we should think twice before killing the $100. The U.S. has a very special to role to play as provider of the world's backup monetary system; it should not take a step back from that role. Criminals, tax evaders, and the lower bound can be punished via alternative means. I'd be less concerned about killing other high denomination notes such as the €500, 1000 Swiss franc, or ¥10,000. That's because inflation-prone economies don't euroize or yenify—they dollarize.

Addendum: If Summers is genuinely interested in combing the world of coins and bills for what he refers to as a 'cheap lunch', then there's nothing better the U.S. can do than stop making the 1 cent coin, which is little more than monetary trash/financial kipple. Secondly, replace the $1 bill, which is made out of cotton and supported by the cotton lobby, with a $1 coin. The U.S. lags far behind the rest of the world in enacting these simple cost cutting efforts.

Sunday, February 21, 2016

Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank

Negative interests rates are the shiny new thing that everyone wants to talk about. I hate to ruin a good plot line, but they're actually kind of boring; just conventional monetary policy except in negative rate space. Same old tool, different sign.

What about the tiering mechanisms that have been introduced by the Bank of Japan, Swiss National Bank, and Danmarks Nationalbank? Aren't they new? The SNB, for instance, provides an exemption threshold whereby any amount of deposits that a bank holds above a certain amount is charged -0.75% but everything within the exemption incurs no penalty. As for the Bank of Japan, it has three tiers: reserves up to a certain level (the 'basic balance') are allowed to earn 0.1%, the next tier earns 0%, and all remaining reserves above that are docked -0.1%.

But as Nick Rowe writes, negative rate tiers—which can be thought of as maximum allowed reserves—are simply the mirror image of minimum required reserves at positive rates. So tiering isn't an innovation, it's just the same old tool we learnt in Macro 101, except in reverse.

No, the novel tool that has been created is what I'm going to call a cash escape inhibitor.

Consider this. When central bank deposit rates are positive, banks will try to minimize storage of 0%-yielding banknotes by converting them into deposits at the central bank. When rates fall into negative territory, banks do the opposite; they try to maximize storage of 0% banknote storage. Nothing novel here, just mirror images.

But an asymmetry emerges. Central bankers don't care if banks minimize the storage of banknotes when rates are positive, but they do care about the maximization of paper storage at negative rates. After all, if banks escape from negative yielding central bank deposits into 0% yielding cash, this spells the end of monetary policy. Because once every bank holds only cash, the central bank has effectively lost its interest rate tool.

If you really want to find something innovative in the shift from positive to negative rate territory, it's the mechanism that central bankers have instituted to inhibit the combined threat of mass paper storage and monetary policy impotence. Designed by the Swiss and recently adopted by the Bank of Japan, these cash escape inhibitors have no counterpart in positive rate land.

The mechanics of cash escape inhibitors

Cash escape inhibitors delay the onset of mass paper storage by penalizing any bank that tries to replace their holdings of negative yielding central bank deposits with 0%-yielding cash. The best way to get a feel for how they work is through an example. Say a central bank has issued a total of $1000 in deposits, all of it held by banks. The central bank currently charges banks 0% on deposits. Let's assume that if banks choose to hold cash in their vaults they will face handling & storage costs of 0.9% a year.

Our central bank, which uses tiering, now reduces deposit rates from 0% to -1%. The first tier of deposits, say $700, is protected from negative rates, but the second tier of $300 is docked 1%, or $3 a year. Banks can improve their position by converting the entire second tier, the penalized portion of deposits, into cash. Each $100 worth of deposits that is swapped into cash results in cost savings of 10 cents since the $0.90 that banks will incur on storage & handling is an improvement over the $1 in negative interest they would otherwise have to pay. Banks will very rapidly withdraw all their tier-2 deposits, monetary impotence being the result.

To avoid this scenario, central banks can install a Swiss-style cash escape inhibitor. The way this mechanism works is that each additional deposit that banks convert into vault cash reduces the size of the first tier, or the shield, rather than the second tier, the exposed portion. So when rates are reduced to -1%, should banks try to evade this charge by converting $100 worth of deposits into vault cash they will only succeed in reducing the protected tier from $700 to $600, the second tier still containing the same $300 in penalized deposits. This evasion effort will only have made banks worse off. Not only will they still be paying $3 a year in negative interest but they will also be incurring an extra $0.90 in storage & handling ($100 more in vault cash x 0.9% storage costs).

Continuing on, if the banks convert $200 worth of deposits into vault cash in order to avoid -1% interest rates, they end up worsening their position even more, accumulating $1.80 in storage & handling costs on top of $3.00 in interest. We can calculate the net loss that the inhibitor imposes on banks for each quantity of deposits converted into vault cash and plot it:

The yearly cost of holding various quantities of cash at a -1% central bank deposit rate

Notice that the graph is kinked. When a bank has replaced $700 in deposits with cash, additional cash withdrawals actually reduce its costs. This is because once the first tier, the $700 shield, is used up, the next deposit conversion reduces the second tier, the exposed portion, and thus absolves the bank of paying interest costs. And since interest costs are larger than storage costs, overall costs decline.

If banks go all-out and cash in the full $1000 in deposits, this allows them to completely avoid the negative rate penalty. However, as the chart above shows, storage & handling costs come out to $9 per year ($1000 x 0.9%), much more than the $3 banks would bear if they simply maintained their $300 position in -1% yielding deposits.

So at -1% deposit rates and with a fully armed inhibitor installed, banks will choose the left most point on the chart—100% exposure to deposits. Mass cash conversion and monetary policy sterility has been avoided.

How deep can rates go?

How powerful are these inhibitors? Specifically, how deep into negative rate territory can a central bank go before they start to be ineffective?

Let's say our central banker reduces deposit rates to -2%. Banks must now pay $6 a year in interest ($300 x 2%). If banks convert all $1000 in deposits into cash, they will have to bear $9 in storage and handling costs, a more expensive option than remaining in deposits. So even at -2% rates, the cash inhibitor mechanism performs its task admirably.

If the central bank ratchets rates down to -3%, banks will now be paying $9 a year in interest ($300 x 3%). If they convert all $1000 in deposits into cash, they'll have to pay $9 in storage & handling. So at -3%, bankers will be indifferent between staying invested in deposits or converting into cash. If rates go down just a bit more, say to -3.1%, interest costs are now $9.30. A tipping point is reached and cash will be the cheaper option. Mass cash storage ensues, the cash escape inhibitor having lost its effectiveness.

The chart below shows the costs faced by banks at various levels of cash holdings when rates fall to -3%. The extreme left and right options on the plot, $0 in cash or $1000, bear the same costs.

The yearly cost of holding various quantities of cash at a -3% central bank deposit rate

So without an inhibitor, the tipping point for mass cash storage and monetary policy impotence lies at -0.9%, the cost of storing & handling cash. With an inhibitor installed the tipping point is reduced to -3.1%. The lesson being that cash escape inhibitors allow for extremely negative interest rates, but they do run into a limit.

The exact location of the tipping point is sensitive to various assumptions. In deriving a -3.1% escape point, I've used what I think is a reasonable 0.9% a year in storage and handling costs. But let's assume these costs are lower, say just 0.75%. This shifts the cash tipping point to around -2.5%. If costs are only 0.5%, the tipping point rises to around -1.7%.

This is where the size of note denominations is important. The Swiss issue the 1000 franc note, one of the largest denomination notes in the world, which means that Swiss cash storage costs are likely lower than in other countries. As such, the Swiss tipping point is closer to zero then in countries like the Japan or the U.S.. One way to push the tipping point further into negative terriotry would be a policy of embargoing the largest note. The central bank, say the SNB, stops printing new copies of its largest value note, the 1000 fr. Banks would no longer be able to flee into anything other than small value notes, raising their storage and handling costs and impinging on the profitability of mass cash storage.

Good old fashioned financial innovation will counterbalance the authorities attempts to drag the tipping point deeper. Cecchetti & Shoenholtz, for instance, have hypothesized that in negative rate land, a new type of intermediary could emerge that provides 'cash reserve accounts.' These specialists in cash storage would compete to reduce the costs of keeping cash, pushing the tipping point back up to zero.

The tipping point is also sensitive to the size of the first tier, or the shield. I've assumed that the central bank protects 70% of deposits from the negative deposit rate. The larger the exempted tier the bigger the subsidy central banks are providing banks. It is less advantageous for a bank to move into cash when the subsidy forgone is a large one. So a central bank can cut deeper into negative territory the larger the subsidy. For instance, using my initial assumptions, if the central bank protects 80% of deposits, then it can cut its deposit rate to -4.6% before mass paper storage ensues.

Removing the tipping point?

There are ways to modify these Swiss-designed cash escape inhibitors to remove the tipping point altogether. The way the SNB and BoJ have currently set things up, banks that try to escape negative rates only face onerous penalties on cash conversions as long as the first tier, the shield, has not been entirely drawn down. Any conversion after the first tier has been used up is profitable for a bank. That's why the charts above are kinked at $700.

If a central bank were to penalize cumulative cash withdrawals (rather than cash withdrawals up to a fixed ceiling) then it will have succeeded in snipping away the tipping point. This is an idea that Miles Kimball has written about here. One way to implement this would be to require that the tier 1 exemption, the shield, go negative as deposits continue to be converted into cash, imposing an obligation on banks to pay interest. The SNB doesn't currently allow this; it sets a lower limit to its exemption threshold of 10 million francs. But if it were to remove this lower limit, then it would have also removed the tipping point.

What about retail deposits?

You may have noticed that I've left retail depositors out of this story. That's because the current generation of cash escape inhibitors is designed to prevent banks from storing cash, not the public.

As central bank deposit rates fall ever deeper into negative territory, any failure to pass these rates on to retail depositors means that bank margins will steadily contract. If banks do start to pass them on, at some point the penalties may get so onerous that a run develops as retail depositors start to cash out of deposits. The entire banking industry could cease to exist.

To get around this, the FT's Martin Sandbu suggests that banks could simply install cash escape inhibitors of their own. Miles Kimball weighs in, noting that banks may start applying a fee on withdrawals, although his preferred solution is a re-deposit fee managed by the central bank. Either option would allow banks to preserve their margins by passing negative rates on to their customers.

Even if banks don't adopt cash escape inhibitors of their own, I'm not too worried about retail deposit flight in the face of negative central bank deposit rates of -3% or so. The deeper into negative rate territory a central bank progresses, the larger the subsidy it provides to banks via its first tier, the shield. This shielding can in turn be transferred by a bank to its retail customers in the form of artificially slow-to-decline deposit rates. So even as a central bank reduces its deposit rate to -3% or so, banks might never need to reduce retail deposit rates below -0.5%. Given that cash handling & storage costs for retail depositors are probably about the same as institutional depositors, banks that set a -0.5% retail deposit rate probably needn't fear mass cash conversions.

So there you have it. Central banks with cash escape inhibitors can get pretty far into negative rate land, maybe 3% or so. And with a few modifications they might be able to go even lower.

Saturday, February 13, 2016

Singapore's $10,000 bill, worth around US$7500, shares title to world's largest value banknote with Brunei's $10,000

Peter Sands has adeptly made the case for eliminating high denomination banknotes. The rough idea is that if all central banks were to eliminate their highest value banknotes, then criminals would have to fall back on smaller denominations or more volatile media of exchange like gold. Since both of these options are more cumbersome than large denomination notes, storage and handling expenses will grow. This means the costs of running a criminal enterprise increases as does the odds of being apprehended.

Elimination of cash is a polarizing topic. For now I'm going to sidestep that debate because I think there's a more interesting topic to chew on: might a central bank be unsuccessful in its attempt to withdraw its own high denomination notes? Put differently, what happens if everyone just ignores a central banker's demands to retire the biggest bill?

Take the most popular high denomination banknote in the world, the US$100 bill. According to the Federal Reserve, there are 10.8 billion of these in circulation, or around $1 trillion in nominal value terms. Popular not only with criminals, the $100 bill circulates in many dollarized or semi-dollarized nations as a legitimate means of exchange in the absence of decent local alternatives. Say that the Federal Reserves wants to hobble criminals by cancelling all 10.8 billion notes. It announces that everyone holding $100s has until January 1, 2018 to trade them in for two $50s (or five $20s). After that date any $100 notes that remain in circulation will no longer be considered money. Specifically, they will cease to be recognized by the Fed as a liability.

Will this demonetization work? Consider what happens if everyone simply ignores the proclamation and continues to use $100s in trade. Say that by the January 1, 2018 expiry date, only $300 billion of the $1 trillion in $100 bills in circulation have been tendered leaving the remaining $700 billion (or 7 billion individual notes) in peoples' pockets.

So much for hurting criminals by removing the $100, right? We'd say that the central bank's demonetization campaign has failed. But not so fast.

Even though 7 billion $100 bills remain in circulation, the nature of $100 bill will have changed. Prior to January 1, 2018, the Fed maintained a peg between the $100 bill and all other denomination ($50, $20, $10, $5, and $1). This peg was enforced by the Fed's promise to convert any quantity of $100 bills into lower denominated notes and vice versa. After the expiry date, the Fed will no longer include the $100 in these pegging arrangements.

In addition to maintaining a fixed rate between the various denomination, the Fed also promises to peg the value of a dollar to a slowly-declining bundle of consumer goods (put differently, it set a 3% 2% inflation target). It does so by injecting an appropriate quantity of new currency into the economy via open market purchases or withdrawing sufficient currency by selling assets. When the Fed demonetizes the $100 note, it ceases to include the $100 in its consumer goods peg. This means it will no longer dedicate any of its assets to protecting the purchasing power of the $100 bill.

Given this new setup, as demand for $100 bills varies their value will float relative to both Fed dollars and the slowly declining consumer good bundle. Like bitcoin, which also has a fixed supply, fluctuations in the purchasing power of the $100 could be quite volatile. One day the $100 might be worth $110, the next it could be worth just $90. So even if the Fed has failed in withdrawing the $100, it will still have succeeded in imposing purchasing power volatility on criminals and other users of the $100. Volatile assets make for unpleasant and costly media of exchange and criminals will not be happy with these change.

By forswearing the $100, the Fed also ceases to act as a guardian of the quality of its issue of $100 bills against counterfeiters. The abdication of this function is especially important given that the marginal cost of printing a decent knock off of the $100 is probably just a few cents. Absent the threat of imprisonment, entrepreneurs will swarm to duplicate the $100, spending counterfeits into circulation and steadily reducing the purchasing power of the $100. After a few years of constant counterfeiting the $100 bill won't be worth much more than a few cents or so; the marginal cost of paper, ink, and printing. This hyperinflation will bring the nominal value of the original 7 billion in notes to just $700 million, down from $1 trillion.

Highest denomination note in various counties, sorted by US$ equivalent

Incidentally, we know this is a likely situation because of what has happened in Somalia. When Somalia's central bank was dismantled in the early 1990s, Somali shillings continued to circulate (see my blog post here). Over the next few years, warlords issued their own counterfeits which eventually drove the value of the shilling down to the cost of paper and transportation. William Luther has described this process here.

Along the way to hitting a terminal value of just a few cents, the $100 will lose any advantage it had previously enjoyed in terms of storage costs and handling. The moment a $100 falls to $49, the Fed's own $50 note becomes a cheaper note for criminals to use. And as the hyperinflation continues and the $100 falls to $19, the Fed's own $20 note will become preferred. The upshot is this: even if the Fed's January 1, 2018 expiry date fails to attract any $100s for redemption, competitive counterfeiting means that the $100 will inevitably cease to be used as the criminal economy's preferred medium of exchange.

Since criminals are rational and can anticipate that this sort of hyperinflation will ensue, they are more likely to tender their notes for cancellation prior to the original January 1, 2018 deadline. Better to get full restitution rather than lose all one's wealth.

Could criminals somehow police against hyperinflation by rejecting counterfeits? Militating against this would be the constant degradation of the note issue's quality due to normal passage of paper from hand to hand. In normal times, the Fed works behind the scenes to keep its note issue up to snuff, replacing worn out specimens with fresh new greenbacks. Once the Fed abdicates this role, $100 bills will quickly start to deteriorate. Picking the counterfeits out from a stack of bills will become more difficult, only making the job of counterfeiting easier.

In the face of this deterioration the mass of $100 bills may begin to fragment and lose fungibility. Fungibility is the idea that all members of a population are perfect substitutes. Well-preserved $100s that are easily identifiable as non-counterfeits may pass at a higher value than a slightly worn out $100, with well-worn and less identifiable $100 bills trading at an even larger discount. Without fungibility, it becomes far more difficult for a medium of exchange to do its job. Where a transaction with fungible $100 notes might be consummated in a few moments, it may take hours to grade a small stack of heterogeneous bills. The costs arising from non-fungibility may be so high that criminals will prefer to use relatively bulky $50 bills which, though possessing higher storage costs, will not be plagued by the requirement that each note be closely analyzed for quality.

So in the end, even if criminals ignore a central bank's deadline to tender notes for cancellation, they will eventually cease using the highest denomination notes through a more roundabout route. A central bank's renouncement of both its role as enforcer of the largest denomination's peg to other notes as well as its commitment to tend to that note's quality will set off forces that drive the purchasing power of those notes down to the cost of paper and ink, at which point they will be as good as demonetized.

Having settled whether a central bank can demonetize its highest value note, should it? That's an entirely different post. Or we can hash it out in the comments.

PS. An alternative story to a Somali-style hyperinflation is an Iraqi-style deflation. See Tony Yates on Twitter. I've written about the odd case of the Iraqi Swiss dinar here. How likely is an Iraqi scenario? Criminals would have to assume that a future monetary authority, maybe even the Fed itself, reverts its decision and undertakes to adopt orphan $100 bills as a liability at a price consistent with their previous purchasing power. This would give $100 bills a fixed value in the present.PPS. On the topic of altering the relationship between high denomination notes and other notes, see my posts on high value note embargoes.

Wednesday, February 3, 2016

With the Bank of Japan reducing rates to -0.1%, many commentators are calling on the Fed to reverse its policy of rate normalization and follow Japan into negative territory. The problem is this. Thanks to the rules laid out in the Federal Reserve Act, the Fed may lack the technical means to dive into negative rate waters. Let me restate this in different terms. If the Federal Reserve were to reduce the rate at which it pays interest on reserves (IOR) to -0.25% or so, the overnight rate may not follow very far. Monetary policy is useless, or at least less effective than it would otherwise be.

Not only would monetary policy lose some of its potency when IOR falls below 0%, but an unapproved fiscal transfer from the Fed to another set of government institutions could occur. This is because negative IOR has the potential to provide a large subsidy to a narrow range of governments sponsored-entities that are allowed to keep 0%-yielding deposits at the Fed. At deeply negative rates, this subsidy could get very large, turning the Fed's substantial profits into large losses. The result, a steady fall in its share capital, might undermine Fed independence and the credibility of monetary policy.**

Why these odd effects? As Nick Rowe says in this delightful post, in a world with negative interest rates everything old is new again, only it's a mirror image. And in a world of negative U.S. rates, the mirror image of the Fed's leaky floor is a sticky ceiling. And just like the leaky floor (more on this later) dragged the overnight rate down to 0% when IOR was positive, the sticky ceiling effectively pulls the overnight rates back up to 0% when IOR is negative. To see why this would happen, we need to take a quick tour of the legal and technical history behind IOR.

Until October 2008 the Fed was legally prohibited from paying interest to banks. Any bank manager who left reserves on deposit at the Fed earned 0%. This changed with the passage of the Financial Services Regulatory Relief Act of 2006 which bolted Section 19(b)(12) onto the Federal Reserve Act allowing banks to "receive earnings to be paid by the Federal Reserve Bank." As a direct result of 19(b)(12), the Fed has been paying interest of 0.25% for a number of years, a rate that was recently increased to 0.5%.

Not only did Section 19(b)(12) provide the Fed with the ability to pay interest on reserves, it also gives it the technical means to pay negative rates on reserves. Now there is some controversy whether the wording in Section 19(b)(12) authorizes a negative rate; for instance, it mentions the paying of earnings to banks, not the payment of negative earnings:

Ex-Fed official Narayana Kocherlakota points out that various members of the Fed Board of Governors, including William Dudley and Stanley Fischer, have already hinted at negative rates as a potential tool, the implication being that the Fed has high confidence in a certain interpretation of the Act that would legally justify the move, otherwise they would not have spoken. Don't forget that Fed general counsel Scott Alvarez will have to sign off on the question of legality. Alvarez is the one who allowed a truck to be driven through Section 13.3 during the credit crisis, legalizing the bailout of Bear Stearns and AIG via Maiden Lane.

Let's assume that there is no legal controversy and the Fed sets negative IOR of -0.25% tomorrow. That's where the Fed's real problems start. Because as I said at the outset, the overnight rate won't follow IOR down in lock-step, it may even stick to the 0% ceiling. On top of this is the aforementioned subsidy provided to those institutions that have access to interest-free deposits at the Fed, namely the government-sponsored entities Freddie Mac, Fannie Mae, and the Federal Home Loan Banks (I'll describe this subsidy later).

As I said at the outset, the sticky ceiling problem is the opposite of the well known leaky floor problem. Over the last few years the various U.S. overnight rates have traded below IOR. These leaks are odd since IOR is supposed to set a lower bound to the overnight rate. After all, why invest your funds at 0.05% overnight when you can get 0.25% at the Fed? We can blame the leakage on our three government-sponsored entities (GSEs): Freddie, Fannie, and the Federal Home Loan Banks. These GSEs are allowed to keep accounts at the Fed but are prohibited from collecting interest. Rather than earn nothing, the GSEs have been lending their reserves overnight to banks who have access to IOR. These banks have been engaging in arbitrage whereby they borrow GSE funds at 0.05%- 0.15% and invest them at 0.25%, a nice gig if you can get it.

From whence this prohibition on interest? 19(b)(12), the same bit of legalese that authorizes IOR, emphasizes that only "depository institutions" can receive interest, and since Freddie, Fannie, and the Federal Home Loan Banks are not depositories, they do not qualify (this article speculates why).

Which means that if the Fed is going to stretch Section 19 authority for payment of interest to allow for the payment of negative interest rates, then the GSE prohibition on receiving positive interest means that they will likewise be exempt from paying negative interest.

The ultimate effect of all this is that if and when the Fed decides to brings IOR to -0.25%%, the overnight rate is going to do a flip—rather than trading below IOR it will start to trade above it. Why the inversion? In positive rate land the IOR exemption meant that it really sucked to be the GSEs. But in negative rate land it's great to be a GSE. When all other banks must endure a -0.25% penalty, an exemption from IOR becomes an asset, not a liability. Banks, sensing a way to improve their returns, will compete to purchase 0% shelter from the GSEs. Say they offer to lend funds to the GSEs in the overnight market at -0.17%, an 8 basis point improvement to IOR of -0.25%. GSEs would be hard-pressed to not accept this gift. After all, they'd be borrowing at -0.17% in order to lend to the Fed at 0%, which means 17 basis points in risk free profit. Taken to the extreme, a profit-maximizing Fannie, Freddie, and the Federal Home Loan Banks will compete to borrow the entire $3.3 trillion in reserves held at the Fed, driving overnight rates back up towards 0%. No matter how deep the Fed brings IOR into negative territory, the overnight rate stays stuck at a shallow level thanks to the GSEs.

You may recognize that the sticky ceiling problem is just another (perhaps weaker) version of the good old zero-lower bound problem, but in the role of 0% cash as antagonist, 0% deposits held at Fannie, Freddie, and the Federal Home Loan Banks have been substituted.

Now it could be argued that GSE arbitrage will force the overnight rate within a hair of negative IOR. For instance, if IOR is at -0.25% the overnight rate might trade at -0.24%. If so, the problem is less about monetary policy impotence and more about the massive subsidy being granted to the GSEs. These institutions have a large incentive to hoover all the reserves held by non-GSEs in order to earn risk free returns. Rather than earning 0.25% on reserves held by banks, the Fed will get 0%. And since the Fed's profits--what economists call seigniorage--typically flows to the taxpayer via the Treasury, taxpayers would be subsidizing Fannie, Freddie, and the Federal Home Loan Banks to the tune of millions, a fiscal transfer lacking the appropriate Congressional approvals.*

If the GSEs take the free gift, this will have very real effects on the Fed's financial health. With IOR at -0.25% the steady rolling-over the Fed's assets will result in a decline in their yields, maybe even negative returns. As the spread between the return on assets and cost of liabilities shrinks, the Fed's seigniorage will drop dramatically. In normal times, a certain portion of this seigniorage goes to rebuilding any impairments to the Fed's capital base while the rest flows through the Treasury to the taxpayer, either in the form of reduced taxes or services. With a 0% loophole being offered to the GSEs, the Fed risks running permanent operating deficits which in turn will lead to a steady erosion in its capital base. If the equity writedowns gets too large this may reduce the Fed's credibility in the eyes of the market, thus reducing the effectiveness of monetary policy.**

The Fed will have to plug this hole if it doesn't want to find itself neutered and/or subsidizing the GSEs. Maybe Fed officials can cap the amount of reserves that the GSEs are allowed to borrow, or use moral suasion to get the GSEs to drop out of the market. Better yet, maybe Fed Chair Janet Yellen can ask Congress to change 19(b)(12) so that, like all other banks, GSEs get to receive IOR (and are forced to pay it). Alternatively, maybe the laws can be altered so that the GSEs are prevented from keeping deposits at the Fed to begin with.

The legal option is a good idea for two reasons. First, it means that negative IOR effectively sets the overnight rate, restoring the pass-through from negative rates into financial markets and the real economy. It also removes the subsidy to the GSEs and the potential for large hits to share capital. Secondly, it fixes the Fed's leaky floor problem at positive rates of IOR. The Fed has already set up an overnight reverse repo agreement (ON RRP) facility to borrow from those ineligible to receive IOR, the idea being to keep a sterner floor under overnight rates. But as Marvin Goodfriend writes, ON RRP

violates the minimal intervention principle of central banking by turning the Fed into a financial intermediary operating directly on a large scale beyond the banking system with the potential to distort short term credit allocation and enable disruptive flight-to-quality flows during periods of financial distress.

Far less obtrusive to fix the leak with a quick change to legislation than fully arming a new battle station.

In closing, if the Fed wants to go negative, it may have some technical details to worry about. Fed officials no doubt already know this. If they don't, the blame can be attributed to their all-out focus on so-called normalization. By throwing all their organizational capital into the creation of a mechanism for keeping rates on an upward trajectory (the ON RRP), the Fed has diverted resources and attention away from the design of a complementary mechanism necessary for a downward rate trajectory. In hindsight, perhaps the Fed should have been tasking half its lawyers, accountants, financial architects, and media personnel to the rate normalization project, and the other to the negative rate project. Time to play catch-up?

Due to the difficulty of this subject matter, I've altered this post a few times since initially publishing it. The general idea has remained the same.* In my original post, this paragraph didn't appear but was in the footnotes. I think it's important enough to bring up to the body of the text.** Added on January 4.*** Since originally posting this, I've softened my position on the sticky ceiling. I originally thought that the overnight rate would stay stuck at 0%, but I now feel it is likely to move closer to negative IOR. It would remain above IOR, however, so the idea of a sticky ceiling, while muted, is still relevant.

Monday, February 1, 2016

Sadly, they won't. They [negative rates] are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times.

Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative. [link]

I disagree. Even if the lending channel is closed, a negative rate policy still sets off a hot potato effect that gets the Bank of Japan a bit closer to hitting its inflation targets and stimulating nominal GDP than without that same policy.

For the sake of argument I'll grant Rochon the point that negative rates might not encourage banks to lend. And as you'll read in the comments here, that would certainly have implications on the effectiveness of monetary policy. But even if we close the door on loans, the interest rate cut will simply find a different route into prices and the real economy.

The moment the BoJ reduces the rate on deposits it creates a hot potato; an asset with a below-market return that its owner is desperate to be rid of. Bank reserve managers will simultaneously try to sell off their BoJ deposits in order to get a better return in short term corporate and government debt. In aggregate, however, banks cannot get rid of reserves, which pushes the prices of these competing short-term assets up and their expected returns back in line with the return on balances held at the central bank, a process that continues until reserve managers are indifferent on the margin between owning BoJ deposits and short term corporate/government debt.

The hot potato doesn't stop here but continues to cascade through financial markets. At the margin, corporate and government debt will now be overvalued relative to other financial assets (like stocks), encouraging fund managers and other investors to bid up the prices of all remaining assets in the financial market until returns are once again in balance.

Up till now the the hot potato that I've been describing has been trapped in Japanese financial markets thanks to Rochon's blocked lending channel. Acting as a bridge into the real economy are the portfolios held by consumers. Japanese consumers own not only portfolios of financial assets but portfolios of consumption goods that yield an ongoing flow of consumption services. Think cars, shavers, tables, and vacations (the latter of which yield a recurring flow of memories). Likewise, financial assets yield an ongoing flow of consumption services since interest payments and the final return of principle can be measured in terms of consumption. When prices in financial markets rise and returns fall, a portfolio of financial assets now yields a smaller discounted quantity of future consumption services than a competing portfolio of consumption goods. In response, consumers will re-balance out of financial assets into undervalued consumption goods, causing consumer prices to rise. Or, if there is some stickiness in prices, the quantity sold experiences a boom.

And that's how the hot potato ignited by the Bank of Japan's negative rates gets passed into consumer prices and the real economy when the lending channel is closed.

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Another interesting critique of the effectiveness of negative rates has to do with the fact that in those nations that have already experimented with negative rates, the penalty has not been passed through to retail deposits. This could be a problem because if Japanese retail depositors are not going to be fined by banks, that nullifies the hot potato effect I described above. After all, consumers won't bother trying to re-balance out of the financial economy into the real economy if they can just hoard superior-yielding 0% deposits.

This failure to pass-through negative central bank rates will probably not be more than a short-term phenomenon. As the BoJ deposit rate get ever more negative, those banks that choose to prop up the rate sthey offer on retail deposits allow themselves to be the victims of arbitrage, consumers taking the positive end of the deal as they migrate into superior-yielding deposits. Borrowing at 0% to invest at -0.1% isn't a particularly profitable place for a bank to put itself in. The only way for a bank to rectify the situation is by the passing-through of negative rates to retail clients or the setting of limits on retail account sizes. The hot potato effect gets new life as investors flee bank deposits by purchasing underpriced consumer goods.

As Gavyn Davies points out, the Bank of Japan has set a tiered negative rate whereby the full effect of negative interest rates is not felt by banks; only a portion of deposits held at the BoJ will be docked the full 0.1% while the rest get off Scot-free. This BoJ (i.e. taxpayer) subsidy to banks helps offset any financial losses that banks incur by choosing to avoid passing through negative rates to retail customers, thus encouraging bank managers to keep retail deposit rates steady at 0%. .

But as the BoJ continues to cut rates, the size of the BoJ subsidy is unlikely to increase as fast as the size of the penalty imposed on banks as measured by the gap between the cost of maintaining 0% retail deposit rates and the revenues earned on negative-yielding central bank deposits & other short term money market assets. To plug these growing losses, and absent a compensating subsidy, banks will have no choice but to pass-through negative rates to retail clients or put a limit on retail account sizes. This in turn will give free rein to the hot potato effect.